CHAPTER 3
THE MEASUREMENT FUNDAMENTALS OF
FINANCIAL ACCOUNTING
BRIEF EXERCISE
BE3–1
1.
2.
3.
4.
5.
Fiscal period
Economic entity
Conservatism
Consistency
Revenue recognition
6.
7.
8.
9.
10.
Materiality
Matching
Objectivity
Objectivity
Stable dollar
EXERCISES
E3–8
a. (1) During 2007 the company changed depreciation methods. This change resulted in an
increase of the book value of the assets versus if no change in accounting method had
occurred. In other words, the depreciation expense went down by the same amount, i.e.,
$5,000. A decrease in the depreciation expenses would increase the net income by the
same amount, i.e., $5,000.
(2) During 2009 the company changed its method of inventory valuation, which also increased
the book value of the inventory. Since the cost of inventory is allocated either to the cost of
goods sold account or to the ending inventory account, this change implies that the Cost of
Goods Sold decreased by $9,000. This would also increase the net income by $9,000.
Overall it seems the company is having a bad year and is attempting to use liberal
accounting policies to paint a “rosy” picture of the operations.
b.
Net income as reported
Effect of depreciation change
Effect of inventory change
Adjusted net income
2006
2007
2008
2009
$ 21,000
0
0
$ 21,000
$ 24,000
(5,000)
0
$ 19,000
$ 23,000
(5,000)
0
$ 18,000
$ 29,000
(5,000)
(9,000)
$ 15,000
The adjusted net income figures indicate that if the company had not changed accounting
methods, it would have reported declining profits. In fact, the company would have reported net
income of only $15,000 in 2009. The reported net income figures have been enhanced with
accounting techniques rather than by sound economic health. Consequently, the company's
performance would be viewed less positively.
c. Companies should adhere to the principle of consistency. This principle states that a company
should use the same accounting principles and methods from year to year. Such a practice
promotes the comparability of the company's financial statements over time and also promotes
user confidence in the financial statements. If a company was free to switch accounting
principles and methods at will, financial statement users would place very little faith in the
statements.
Under certain conditions, companies may switch accounting principles. The primary condition
that must be met before a company may switch methods is the approval of the company's
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auditors. The company must convince its auditors that the environment it faces has changed
sufficiently so that the new accounting principle, rather than the old principle, more appropriately
reflects the company's financial position and performance.
PROBLEMS
P3–11
a. Hydra Aire would recognize the following revenue in each of the 3 years based on the number of
toasters produced times the selling price per toaster.
Year 1:
Year 2:
Year 3:
200 
200 
100 
$100
$100
$100
=
=
=
$20,000
$20,000
$10,000
b. Hydra Aire would recognize the following revenue in each of the 3 years based on the number of
toasters delivered times the selling price per toaster.
Year 1:
Year 2:
Year 3:
150 
200 
150 
$100
$100
$100
c.
Assumption 1
Revenues (from part [a])
Expenses
Net income
=
=
=
$15,000
$20,000
$15,000
Year 1
Year 2
Year 3
Total
$20,000
8,000 *
$12,000
$20,000
8,000*
$12,000
$10,000
4,000*
$ 6,000
$50,000
20,000
$30,000
* Expenses = Number of units produced  $40 per unit.
Assumption 2
Revenues (from Part [b])
Expenses
Net income
Year 1
Year 2
Year 3
Total
$15,000
6,000 *
$ 9,000
$20,000
8,000*
$12,000
$15,000
6,000*
$ 9,000
$50,000
20,000
$30,000
* Expenses = Number of units delivered  $40 per unit.
d. If Hydra Aire’s management is compensated based on the net income of the company, they
would prefer to recognize revenues at the point of production. Why? Because it results in higher
net income in year 1 and therefore in a higher bonus for the management.
ISSUES FOR DISCUSSION
ID3–2
a. Priceline’s method of booking revenue has the potential to mislead investors. It is not the same
method that traditional companies in this industry use. It does not make sense from the
standpoint that Priceline is reporting revenues for products and services that it does not provide.
Priceline is not an airline or a hotel but yet is reporting the revenues that relate to those
activities. Priceline provides a service of matching buyers and sellers (like stock brokers) and
should only report revenues that relate to the service that it actually provides.
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b. If investors are going to value the stock of a company based on a multiple of revenue then
management has an incentive to report the highest amount of revenue as possible. So by
reporting these “gross bookings” as revenue Priceline is able to increase its stock price. This is
particularly significant for a company that is losing a lot of cash in its operations. The most
common way for a company that is losing cash from its operations is to raise money by selling
stock. Typically companies that are losing money do not have the option of issuing bonds and
so the only way the company can fund itself is to sell stock. A higher stock price allows the
company to give up fewer shares for the needed amount of cash.
c. Allowing internet companies to record revenues differently than traditional companies has a
couple of impacts, both of which are negative. One of the goals of GAAP accounting is to have
financial statements comparable from one company to another. If different accounting methods
are used then this is not possible. If investors are going to value the stock of a company based
on a multiple of revenue then management has an incentive to manipulate this number. It is
much easier to manipulate revenues than net income.
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